The Bank for International Settlements siren calls that central banks around the world should be raising nominal interest rates to choke off an orgy of risk taking grabbed more attention on the chatosphere than I expected, since this is what they always call for, and their reports make for more forecastable reading than the output of lobby groups for pensioners.

I was particularly struck by the pointed remark by the BIS that central banks themselves were not to be trusted to make the right judgement trading off risks to growth and financial stability, since they had failed to predict the 2008 financial crisis. This is a rare personalisation of the issue. Policy committees have turned over substantially since pre-crisis times. Some committees [like the UK’s financial policy committee] didn’t exist at the time they were meant to be foreseeing the crisis. This is a rather lazy remark by the BIS. If one wanted to engage in such public banter, one might draw attention to the fact that, like a stopped clock forecasting midnight, the BIS predicted a financial crisis every quarter for the best part of two decades and were eventually bound to be right. Or, with the rhetorical equivalent of the sliding tackle, we might urge that people ignore the BIS’s interest advice because they have presided over a dilute and inadequate tightening of a capital adequacy regime that was proven and is still too complicated, all without complaint.

As Simon Wren-Lewis points out, the BIS discussion of the issue is extremely one-sided. They fail to appreciate the gravity of the risks of greatly prolonging time spend at the zero bound and an associated period of deflation, or lowflation, especially considering the relative efficacy of instruments for tightening [taxes, interest rates, macro-pru] as against instruments for loosening [forward guidance, almost expended, and QE/credit easing, likewise]. The BIS seem to omit to mention that overly tight policy carries its own financial stability risks. Canadian and Australian banks survived the crisis because their banks were lending into a private sector experiencing windfall booms. A monetary-policy induced recession would increase firm deaths, increase unemployment, and weaken the balance sheets of banks lending to those dying firms and unemployed mortgage holders.

In my opinion they don’t give enough credence to the observation that monetary policy is, fundamentally, a weak tool for dealing with real phenomena, especially those that are slow-burning [highly apt description for financial stability problems] and have real causes [the BIS contest this in this case, with some merit]. A driving force for this argument is the BIS’ intriguing research on the ‘risk taking channel of monetary policy’. This is manifest in a number of micro studies which show how the riskiness of loans correlates with nominal rates. And the theory that credit market institutions mitigate towards what should be real decisions about the risk-return trade-off being affected by nominal, rather than real rates.

These views for me have the status of dissident challenges awaiting further work, rather than new wisdom around which monetary frameworks should be arranged. One way of ensuring that interest rates are high forever would be to announce a permanent increase in the inflation target of 5%, or 10%. Presumably the BIS wouldn’t be in favour of that, and would not argue that ‘risk taking’ would be forever cured by higher steady-state inflation. And if not, what exactly is the argument? Over what horizon, if not the long-run are tightenings effective at curtailing ‘risk-taking’? Interest rates have been at their floor for 20 years in Japan. Do we think that the Japanese economy is suffering from irrationally-exuberant risk-taking?

The correlations in these studies are just that, and not conclusive proof of a risk-taking channel. And if one wants to get serious about pervasive, long run money-illusion, we should be even-handed about it. If we apply the same logic in labour markets, then a tightening that forced down prices, in the presence of unyielding nominal wages, would price workers out of jobs.

Should that statement not be qualified? Presumably you mean that monetary policy can only reliably deal with nominal not real variables. But the relationship between nominal and real variables will be itself highly variable depending on the era and the state of various markets, surely. In 1975, more NGDP did not mean more RGDP. In 2011, less NGDP did mean much less RGDP. So does it not depend entirely on the slope of various curves? In the last year, more NGDP than forecast has led to more RGDP than forecast.

Apologies if this seems like a chiselling query to another educational post

Flattery! I’m referring to the view in the many studies that followed Sims’ work in identifying monetary policy shocks – unsystematic changes in interest rates, in the modern era, and measuring their impact on real variables. Which while considerable and persistent, still ultimately fades away, over a few years or so. This view is also build into DSGE models of monetary policy. The classic references that does the 2 is Christiano-Eichenbaum-Evans 2000. You’re absolutely right that the statement should be qualified. For example, a monetary policy shock that succeeds in contracting the economy toward the zero bound could have a very large effect on real variables. So it does depend on the shape of various curves. But in the region that the BIS are referring to, those shapes lead me to believe that expansionary monetary policy should not have very long lasting effects on real portfolio decisions, and should not therefore be considered a primary causal factor in the last crisis [instead due to 20-30 years of regulatory neglect in the face of financial innovation] nor of the next one. For the same reason, tightening monetary policy, while it would, along some channels, have a tempoary ameliorating effect on risk-taking behaviour, along others it might aggravate riskiness itself, and anyway the former channel would dissipate, requiring a real tool to take up the slack at some point anyway. The other connections to make from my ridiculously brief sentence in the original post that you rightly siezed on is the empirical literature on money neutrality and super neutrality. This goes something like this: long run changes in money growth in standard models typically have a small long run deleterious effect on the level of output [the statements I made early were about temporary changes in interest rates and temporary changes in money growth] but do not have any long run effect on the growth rate of output. These views can be supported by empirical studies, but are controversial. But ditching them would require reassembling the monetary canon totally.

Dear Tony,
as a non-economist I am trying to understand the BIS concept and how it relates to the conventional wisdom. I think I got some clues but not all and as you seem to be so knowledgeable with all the details I wondered whether you could help me out.
In essence, I am trying to understand how that risk-taking channel differs from what the “conventional model” would tell you about how monetary policy works. So, to make it short and in simple terms for me as a non-pro: what is all the fuss about monetary policy accomodating prolonged financial cycles. Is it really just that monetary policy changes risk-perceptions and if so, how do they get to the argument that this can lead to long-lasting distortions? And how would “conventional models” as used before the crisis see the effect of monetary policy on the financial sector? Would they merely reduce this to saying that there may be frictions but in essence monetary policy does not affect leverage and credit provision in the long-run?

Apologies for these very naive questions but I would be thankful if you could help me with that!